Two developments played a major role here. First, with oil prices standing high, oil and gas companies increased their sales and profits and started making relatively more tax payments to the budget. Second, the tax legislation has changed in a way that has increased the oil price elasticity of tax payments in the sector. The most important changes have included the increased progressiveness of oil export duties and the introduction of a linear relationship between oil prices and the statutory rate of the tax on the extraction of mineral resources in the oil sector. Both taxes are paid mainly to the federal budget, making it very sensitive to changes in oil prices. In the present price range, every dollar-per-barrel change in oil prices increases or decreases the enlarged budget revenues by 0.45 percent of GDP, out of which the share of federal budget is three-quarters.

1.6 Since 1998, there have also been considerable developments on the expenditure side of the budget, which point to both the large fluctuations in and the pro-cyclicality of budget expenditures (see Table 1.1). After the initial decline to 29.0 percent of GDP in 2000 from 43.7 percent in 1997, the enlarged budget non-interest expenditures recovered by 5.percentage points of GDP in just two years (2001-02) and reached 34.4 percent of GDP. The increase in total budget expenditures was less pronounced since GDP growth and the policy of budget surpluses helped to reduce both the stock of public debt and the size of annual interest payments.

1.7 The social expenditures of the enlarged budget (i.e., expenditures on education, health, and social protection) have had a clear pro-cyclical pattern in the past. They experienced the largest reduction (by more than 50 percent in real terms) during the post-1998 fiscal consolidation, which was followed by a strong increase thereafter. Within social expenditures the after-the-crisis recovery largely financed the growth of recurrent expenditures, such as wages, pensions, etc. Inter alia, this also included the financing of increased staffing levels in the civil service and budget sectors (such as health) at the subnational level (World Bank, 2003b). Apparently, recurrent expenditures on wages in the public sector and household social benefits are those which would be the most difficult to compress politically should a fiscal adjustment be required if and when budget revenues fall together with oil prices.

Responding to the 1998 crisis, they fell to 14.4 percent of GDP in 1999 from 19.0 percent in 1997. Expenditure rationalization made by the government resulted in their further decline to 13.9 percent of GDP in 2001 before growing to 14.7 percent in 2002, presumably on the wave of the oil windfall spending and general fiscal policy relaxation. In 2003 the government managed to reduce these spending somewhat in relative terms to 14.4 percent of GDP.

1.9 While most of the non-interest non-social expenditures behaved pro-cyclically, some of them did not. More specifically, expenditures on agriculture, liquidation of emergencies and natural calamities, and state industrial funds have declined in percent of GDP terms since 2000. In this way these expenditure cuts smoothed the pro-cyclicality of overall non-social budget expenditures.

1.10 As one would expect, among the items of functional classification, budget spending on both public investment and subsidies to industrial producers (net of subsidies to SMEs) proved to be the most pro-cyclical expenditure category. These spendings fell more than threefold in 1997-99 -- from 2.1 percent of GDP to 0.6 percent. They then increased to 2.percent of GDP in 2003. This was the only broad expenditure category that exceeded its relative (as a percent of GDP) pre-crisis level.

Medium-term fiscal prospects and debt sustainability 1.11 The fiscal surpluses of the general government recorded since 2000 have drastically improved Russia’s debt profile and have practically eliminated the debt sustainability problem that was a major macroeconomic and fiscal problem for Russia in the 1990s (Figure 1.1).

Recent analysis of Russia’s debt sustainability suggests that trends in the total public debt should be easily manageable under a broad set of possible scenarios (IMF, 2003). Under the baseline scenario, it is expected that the average primary surplus of the general government would amount to 1 percent of GDP in 2007-09, while the average primary balance of the federal government would amount to 1.7 percent. This is under the assumption of average GDP growth of 5 percent, external debt interest rate of 5 percent, and a considerable slowdown in ruble real appreciation after 2006.

1.12 Even in the low-case scenario the debt would stabilize at a level below 30 percent of GDP. In addition, stress tests showed that under the most gloomy macroeconomic assumptions (such as high external interest rates, a significant fall in GDP, considerable depreciation of the ruble) the debt dynamics, measured by the public debt-to-GDP ratio, would deteriorate only temporary, and would still remain under control in the longer term (See Table 1.2 that is based on IMF, 2004). Moreover, since early 2004, when the most recent analysis was carried out, skyrocketing oil prices have made the public debt profile in Russia even stronger, making public debt sustainability of even lesser concern.

1.13 However, Russia remains highly vulnerable to external shocks associated with oil prices. Should oil prices drop significantly and remain at the low level, a sizable adjustment in exchange rate and fiscal policy would be required. In addition, short-term liquidity crunches caused by adverse oil price shocks could lead to substantially lower GDP growth rates (IMF, 2004). Also the sustainability of the country’s total external debt is of somewhat more concern, taking into account a rapid accumulation of foreign debts by the private sector.

Significant ruble depreciation could lift the total external debt to an unsustainable level.

1.14 Notably, the public debt sustainability does not mean that Russia does not have any problems in the area of debt management. Many OECD countries chose their longer term debt targets at the levels that are considerably below their debt sustainability thresholds. It is assumed that even sustainable debt dynamics might be detrimental for the economic growth if the debt level is relatively high.1 Various studies estimated that the optimal debt level for individual G7 countries falls in the range of below 20 to 50 percent of GDP.2 Clearly, for less developed countries, such as Russia, the optimal debt level should be lower than in the Gcountries, owing to higher country risk premiums, a higher share of hard currency debts in the debt structure, and the lesser efficiency of the public sector.

B. FISCAL COSTS OF KEY STRUCTURAL REFORMS 1.15 In spite of the significant progress achieved in building market economy during the 1990s and early 2000s, Russia still needs to accomplish a number of structural reforms, which would advance the development of its market institutions and level up the public sector efficiency. The implementation of structural reforms usually requires budget financing and can be rather costly. Depending on the specifics of a particular reform, these costs may be of a temporary or permanent nature. From a fiscal viewpoint, launching a structural reform represents incremental, irregular spending with stronger or weaker feedback to regular expenditures. This issue is of paramount importance for Russia, which is committed to carrying out multiple structural reforms simultaneously.

1.16 All structural reforms can be divided into three groups by the fiscal costs they incur.

The first group consists of those reforms that require only initial one-off financing for a limited time period or those that, with time, generate budget savings that offset their fiscal costs if the latter are of a permanent nature. Examples include the elements of both education reform and pension reform. In particular, a switch to the system of unitary state exams (USE) for high school graduates requires investment in the institutional infrastructure for these exams, expenditures on pilots, and the like. Once it becomes operational, the USE would replace the current system of university entry exams that is presently administered by individual universities. The annual costs of undertaking the USE would be offset by savings in the costs of university admission. In pension reform, establishing a fully funded pillar gives rise to a fiscal gap in the pay-as-you-go part of the pension system a few years down the road, which will disappear when the funded pillar starts to co-finance pension benefits. However, in the meantime, either the temporary medium-term fiscal gap in the pension system will have to be financed from the budget, or the real value of benefits to the current pensioners will be lower in real terms than for both the preceding and the following generations of pensioners.

1.17 There are two important specific sub-groups of reform initiatives that could be identified within this first group of reforms:

• Structural reforms to be implemented at the subnational level, the early implementation of which could be unattractive for regional leaders (e.g., because of their perception of additional political risks). Under the circumstances, the federal government could be interested in establishing a special support mechanism to provide fiscal and administrative incentives to regions that are ready to pilot specific regional reforms. The recent quite successful experience with the Federal Fund for Regional Fiscal Reforms (FFRFR) provides a possible model for the organization of such a federal support mechanism. It is worth emphasizing that, even in cases where the reforms themselves may not lead to additional fiscal costs (as in the case of reforms in residential housing), some modest costs for the federal government could arise from a need to establish a proper incentive framework for launching reform pilots in the regions. This relates primarily to the sectors that are primary responsibility of subnational governments.

• Reforms to promote new private sector institutions, currently missing in Russia, which could generate considerable long-term externalities. One-time public investments in such institution building could reduce the future costs of market entry for private operators. Examples of such missing or severely under-developed institutions include entities that would provide student loans and venture fund industry. The government’s co-financing of such institutional pilots could take the form of either co-investments or guarantees for private investors against noncommercial risks.

1.18 The second group comprises reforms that demand a permanent increase in financing through possible budget savings are not sufficient to cover their costs, even in the long term.

Civil service reform is one example of such a reform. As estimated in Chapter 2, it would cost the budget 0.9-1.3 percent of GDP annually, of which 0.5-0.7 percent would be the costs to the federal budget. These permanent additional spendings are needed to make salaries in the civil service compatible with those in the private sector, as well as to increase non-wage costs in the civil service (such as on training and retraining, office equipment and telecommunications, etc.). Without this, it would be difficult to ensure a drastic improvement in the efficiency of the civil service in Russia.

1.19 Structural reforms belonging to the third group are those that generate expenditure savings without any substantial fiscal costs for the budget. Housing reform appears to be an example of such a reform. Phasing out producer subsidies in the housing and communal services sectors and phasing in the targeted subsidies to poor families would generate substantial net budget savings, as experience has shown. In addition, potentially massive outflows from the budget to rehabilitate the communal infrastructure could be minimized. A system of performance management contracts and utility concessions can make it profitable and attractive for private companies to invest in the communal infrastructure, which would remove this burden from the budget.